Money Supply Problem
You are hired by the Chair of the Federal Reserve to manage the trading desk at the New York Fed and the Chair tells you that he wants you to increase the money supply (M1) by 33 percent. They warn you to be careful because in these uncertain times, the money multiplier tends to become very unstable. They suggest that you stay ‘closely connected’ with the banking sector and then gives you a list of phone numbers to do so. Note that in this problem we are targeting the growth rate of M1.

Reserve Market Initial Conditions (Scenario A)
rr/D= .10
C = 400 b
D = 2000 b
ER = 0 (not a typo)
M = C + D

Use the initial conditions IN SCENARIO A above to answer #1-3.

1. What is the MB?

2. What is the money multiplier?

3. What is the money supply? Use mm x MB to calculate this.

4. Scenario B: So you decide to inject $100 billion in reserves via open market purchases with phone in hand. Recall, the Chair said to watch that multiplier and so you start making some calls. Just as you suspected, the banks aren’t making any loans, that is, they are sitting on all $100 billion in excess reserves.

Given these new conditions from SCENERIO B, answer #4-6.

What is the MB?

5. What is the money multiplier? Round to 3 decimal places.

6. What is the money supply? Use mm x MB to calculate this and Round to the nearest whole number.

7. Now the Chair calls and asks you how things are going and you tell him/her that you injected $100 billion in the system but it didn’t work because banks are holding on to the ER (the banks never loaned them out, they hoarded them instead).

Scenario C: Now you get some calls from bankers and you learn that there has been some ‘internal substitution’ within the M1 money supply. In particular, households prefer to hold more currency relative to deposits, i.e., the currency to deposit ratio rises. The new numbers are as follows:
rr/D= .10
C = 800 b
D = 1600 b
ER =100 b

Use the new conditions from SCENARIO C to answer #7-9.

What is the MB?

8. What is the money multiplier? Round to 4 decimal places.

9. What is the money supply? Use mm x MB to calculate this and Round to the nearest whole number.

10. Scenario D: Now the Chair is not pleased with your work, and calls again. Assuming that the money multiplier is now stable (i.e., the value you found in #8), you need to figure out what to do, in terms of open market operations, to hit the 33 percent money growth rate desired by the chair and the FOMC. To do this you must first identify the target money supply. Then you will be able to calculate the needed monetary base and finally you will be able to calculate the amount of open market purchases/sales. Work through these steps in #10 – 12.

Your goal is to increase the money supply by 33%. Use the Money supply you found in #9 and increase it by 33%, the target money supply is:

11. The money multiplier is stable at the value you found in #8. Use it and your answer from #10 to calculate the appropriate monetary base. Round to the nearest whole number.

12. NOTE: no graphing was required for Part 1. However you should be comfortable graphing the monetary base graph and the money supply graph for part 1. These graphs will be shown in the solutions so that you can check your understanding.

An open market _______of ______ must occur to reach the monetary base found in #11 above(hint: take your answer from #11 and subtract your answer from #7).

13. We are going back to the fall of 1998, back in the ‘midst’ of the new economy. The U.S. economy weathered the E. Asian quite well and the U.S. economy, by almost all accounts, was performing brilliantly. In August of 1998, Russia defaulted on all the debt held by foreign investors. This “shock” rattled financial markets so much that the Fed went into action and lowered short term interest rates 3 times in a seven week period. In what follows, we are going to model this 7 weeks period using our new acquired reserve demand / reserve supply diagram.

Here are the relevant dates and interest rates:
Point A: August 1998: iff = 5.5%
Point B: September 1998: Lowered interest rates to iff =5.25%
Point C: October 1998: Lowered interest rates to iff = 5.00%
Point D: November 1998: Lowered interest rates to iff = 4.75%

Note importantly, we are modeling the behavior of the federal funds rate during this period. The forecasted reserve demand at this time is given below. For simplicity, this reserve demand function is stable (constant) throughout this exercise:
Rd = 900 – 100 iff

What is the value of the Reserve Supply in August 1998? Hint: use the Rd equation and the value of iff to get the value for Rd. Then remember that Rd=Rs in equilibrium!

14. For questions 14, 16, 19 and 21, all of your answers will be submitted using the same graphing template. When those questions are completed, scan the graph and use the “Upload File” button under question #22 to submit your graph.

On the graph provided in the graphing template, Sketch out the Reserve Demand and label it Rd. Then add the reserve supply associated with #13 above and label it RSA. Then label the intersection of the Rdand Rs as point A. Label the value for iff and the value of the reserve supply on the horizontal axis.

15. What is the value of the Reserve Supply in September 1998?

16. On your graph in the graphing template, add the reserve supply associated with #15 above and label it RSB. Then label the intersection of the Rd and Rs as point B. Label the value for iff and the value of the reserve supply on the horizontal axis.

17. Is this change in the Rs due to open market purchases or sales?

18. What is the value of the Reserve Supply in October 1998?

19. On your graph in the graphing template, add the reserve supply associated with #18 above and label it RSC . Then label the intersection of the Rd and Rs as point C. Label the value for iff and the value of the reserve supply on the horizontal axis.

20. What is the value of the Reserve Supply in November 1998?

21. On your graph in the graphing template, add the reserve supply associated with #20 above and label it RSD . Then label the intersection of the Rd and Rs as point D. Label the value for iff and the value of the reserve supply on the horizontal axis.

22. If the excess to reserve deposit ratio goes up along with the currency to deposit ratio, all else constant, then we are unsure what happens to the money multiplier since the money multiplier is negatively related to the excess reserve to deposit ratio but positively related to the currency to deposit ratio.

23. During each FOMC meeting policymakers discuss the current state of economic affairs in each of the 12 regional districts that make up the US. In fact, the Presidents of all the regional Federal Reserve Banks attend all FOMC meetings and discuss the conditions in their respective districts.

24. If the Fed was worried about overheating (GDP growing too fast, inflationary pressures building), then the appropriate open market operation would be for the Fed to conduct open market sales.

25. The FOMC meets in Washington DC but the action, in terms of conducting open market operations takes place at the New York Fed (FRBNY).

26. During the Great Depression, the excess reserve to deposit ratio rose for a variety of reasons. The impact on the money multiplier was negative. That is, all else constant, a higher excess reserve to deposit ratio lowers the money multiplier.

27. In the lectures, we argued that the money (M1) multiplier (since October 2008) has been rising given that banks have been ‘hoarding’ money (due in part to the fact that the Fed is paying interest on excess reserves) resulting in a rise in their respective reserve to deposit ratios.

28. If the money multiplier is 3 and the Fed conducts $100 billion of open market sales, then the money supply will increase by $300 billion.

29. If the money multiplier falls by 50%, then the Fed, to keep the money supply constant, would have to double the monetary base.

30. Prior to October 2008, the M1 money multiplier was trending downward since the required reserve ratio administered by the Fed was trending upward.

31. According to the quantity theory of money in percent change form, then if velocity falls so that its growth rate is negative then the Fed, to keep inflation and output growth stable, should match the decrease in velocity with an equivalent increase in the percent growth of the money stock.

32. According to Milton Friedman, inflation is always and everywhere, caused by excessive economic growth.

33. The reason that the existence of money increases efficiency in the economy is that it allows society to avoid the double coincidence of wants and therefore, allows people to specialize in what they do best.

34. Assuming that the nominal return on money is equal to zero, the real return to holding money is the inflation rate.

35. The largest component of household sector wealth is wealth in the stock market.

36. M2 is more liquid than M1 since M2 includes traveler’s checks where M1 does not.

37. The FOMC meets every month unless conditions warrant more frequent meetings.

38. The Philadelphia Federal Reserve Bank is responsible for monitoring economic activity in their district which includes the economic activity in State College, PA.

39. According to the lecture discussing the October 2012 FOMC statement, the Fed plans on buying $85 billion per month in longer term securities in hopes of lowering long term interest rates.

40. According to the lecture discussing the October 2012 FOMC statement, they plan on keeping their target for the federal funds rate in the range of 0 – .25% at least through mid 2015.

41. All regional bank presidents of the Federal Reserve system vote at all FOMC meetings.

42. Open market operations influence reserve supply. For example, an open market sale will increase reserve supply.

43. According to our discussion on the FOMC statement from August 2007, the Fed was worried about inflation getting too high.

44. Following the 2001 recession (aka, the job-loss recovery), the Federal Reserve lowered their target for the federal funds rate all the way down to 1%.

45. Following the job-loss recovery, the FOMC raised the target for the federal funds rate 17 meetings in a row.

46. Since December 2007, the federal funds rate has been at the zero bound with the official target being a range from zero to .25%.

47. During the lead up to Y2K, reserve demand was decreasing since banks were afraid to make loans.

48. During the lead up to Y2K, the Fed, to keep the federal funds rate from rising, had to conduct open market purchases. This action is referred to as ‘accommodating’ the shock to reserve demand.

49. During normal times, before the zero bound, the Fed forecasts reserve demand and supplies the necessary reserves to meet their federal funds target. The better the forecast, the closer the actual federal funds rate is to the target federal funds rate.

50. In order to raise the federal funds rate the Fed would conduct open market sales.

51. When discussing money demand, we argued that people tend to hold more money as the interest rate rises, all else constant.

52. If the Fed conducts open market sales then the price of bonds should fall.

53. According to our money demand / money supply analysis, an increase in GDP = Y, all else constant, will result in a rise in nominal interest rates.

54. According to the percent change form of the quantity theory of money, if velocity falls by 10%, then the Fed, in order to achieve their dual mandate, should let the nominal money supply grow by 15%.

55. A portfolio shock such that households want to hold less money, at any given interest rate, will result in the velocity of money falling.

56. Milton Friedman felt that high inflation was always caused by excessive money growth. In fact, he has been quoted as “Inflation is always and everywhere a monetary phenomenon.”

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